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SEC Voices Concern about "Eye-Popping" Startup Valuations

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Shriram Bhashyam   April 04, 2016

I recently wrote an article for TechCrunch analyzing a speech given by SEC Chair Mary Jo White in Silicon Valley. This is a positive development towards the evolution of transparent, deep, and orderly private secondary markets. As always, we at EquityZen seek to keep our community informed of relevant updates. 

Consider it an early warning, or maybe a gentle reminder from your friendly securities regulator. Securities and Exchange Commission (“SEC”) Chair Mary Jo White came to the heart of Silicon Valley to deliver a speech at Stanford University’s Rock Center for Corporate Governance on March 31, 2016, which touched on a variety of topics but was rather forthright in addressing startup valuations. Management and boards at late stage, or pre-IPO, companies are on notice that the SEC is paying attention to the late stage financing arena, and should look internally to ensure that corporate governance and financial controls are befitting their scale, and should also ensure the accuracy of the disclosures they make when raising funds.

Job number one of the SEC is investor protection. Viewed through this lens, it makes sense that the SEC would start paying attention to what’s going on in the world of Unicorns and their “eye-popping”, as Chair White put it, valuations. To be fair, late stage financing occurs in the private markets, where the players are sophisticated and typically understand the risks associated with growth stage investing. However, these financings are still subject to basic securities laws requirements, including the accuracy of information provided to prospective investors in these companies, which Chair White openly questioned. She was concerned that the motivations to achieve a high valuation may lead to impropriety in disclosures. Chair White noted, “In the Unicorn context, there is a worry that the tail may wag the horn, so to speak, on valuation disclosures. The concern is whether the prestige associated with reaching a sky high valuation fast drives companies to try to appear more valuable than they actually are.” It’s well-known in Silicon Valley that valuation itself has become a KPI, whether for noble reasons (recruiting talent) or not (valuation as vanity metric).  Chair White wondered aloud “… whether the publicity and pressure to achieve the Unicorn benchmark is analogous to that felt by public companies to meet projections they make to the market with the attendant risk of financial reporting problems.” The SEC has now reminded companies that these motivations and pressures do not excuse bending the rules by inaccurately reflecting company performance. 

Further, the SEC is keenly aware that the risk of inaccuracy is increased at startups because they tend to have looser internal controls than their public counterparts (Zenefits is the glaring example here). Accordingly, Chair White stressed the importance of financial controls and corporate governance at pre-IPO companies...

Continue reading at TechCrunch.

Option Exercise Checklist for Founders


Shriram Bhashyam   August 27, 2015

So you've made the leap and founded a company. Awesome. You've incorporated and got your corporate starter kit in order (bylaws, stock plan, forms of equity docs, etc.). Sweet. Most importantly, you've convinced talented people to join you on this wild ride to build something amazing. Hearty congrats. Now it's been a year and your first hires, the ones who helped you ship your MVP and gain traction, are exercising their options. We recently experienced this at EquityZen, and while it's incredibly fulfilling to see your team members excited about exercising their options and owning their shares, it's also a bit daunting. Here's a checklist--based on our experience--to make sure you're covering your bases for the company and your employees.

This checklist assumes that Incentive Stock Options, or ISOs, (more info on that here) are being exercised by a current employee (there are a few tax wrinkles for NSOs and best practices for former employees that we don't address here).

o        Review the exercise notice and make sure it's been properly completed. Be sure to double check the type of options being exercised (ISO/NSO).

o        Confirm that the options being exercised have actually vested (or are eligible for early exercise). Vesting is typically over a four year schedule with a one year cliff (before which zero shares will have vested). Once the cliff is crossed, 25% of the grant will have vested, and there after the option will vest in equal installments (usually monthly, but sometimes quarterly) over the remaining three years. Keep in mind that it's possible for a fractional number of shares to vest at the cliff and/or on the following monthly schedule. In that case, you can round down for the vesting at the cliff and monthly vest amount, and then make up the sum of the fractional shares in month 48.

o        Now's also a good time to review your records to ensure you have the whole story of the employee's stock: the board resolution authorizing the grant, the grant document, and your capitalization table (here's a handy excel template we made for cap tables).

o        Confirm compliance with Rule 701. Rule 701 is an exemption from registration of securities for equity awards granted pursuant to equity compensation plans. Under Rule 701, aggregate sales price of securities sold or options granted cannot exceed, in any 12 month period, the greater of:

                        i.         $1 million,
                       ii.         15% of the company's total assets (as measured against the company's most recent fiscal year-end balance sheet), or
                     iii.         15% of the outstanding amount of class of securities being offered and sold in reliance on the rule (as measured against the company's most recent fiscal year-end balance sheet).

o        Confirm the company does not need to make a new fair market valuation assessment. More info on that here and here.

o        Countersign the exercise notice and make sure the company and the employee execute a stock option exercise agreement, stock restrictions agreement, or equivalent. This is an agreement that governs the ownership of shares the employee now owns.

o        Provide disclosure to the employee about risks and restrictions associated with purchasing private company shares (not required but worth considering).

o        Update the company’s cap table to reflect the exercise.

o        Have company counsel prepare a stock certificate (or if the company uses a book entry system, make sure the exercise is properly recorded on the ledger).

o        File IRS Form 3921 (by February 28 of the year following exercise) and provide a copy of the form to the employee (by January 31 of the year following exercise).

o        Check whether any "blue sky" filings are required. "Blue Sky" laws are state securities laws and can require notice filings in connection with the exercise of options. Check whether the state of residence of the employee requires such a filing. Generally, these filings are required within 15 days of sale in the state.

This post is for informative purposes only and does not constitute tax or legal advice. Consult your legal or tax advisor for advice specific to your circumstances. Links to websites outside of our domain do not constitute an approval or endorsement of the content on those websites.

Why Founder Lane Becker Was "Washed Out" of the Get Satisfaction Sale

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Shriram Bhashyam   April 30, 2015

Lane Becker, co-founder of Get Satisfaction, a community building platform between companies and customers, made waves on Twitter a few weeks back when he reacted candidly to congratulatory tweets about Get Satisfaction's acquisition by Sprinklr. As you see from the tweet above, he didn't see any financial return on the deal. This despite the fact that Get Satisfaction had raised a $10 million Series B round from leading VCs at a $50 million valuation in 2011. Why did he get washed out?

Lane opened up to Business Insider and cited two main reasons: giving up too much control to VCs and a lack of self-awareness among management about where their business was when taking so much money at a lofty valuation. As Lane put it in an interview with Business Insider:
We took a $10 million investment very prematurely.... At the time we were entertaining some acquisition offers. In hindsight, they would have been wise acquisition offers to take. The executive team got stars in their eyes about the money and took the investment. When you raise $10 million at a $50 million valuation, that is a serious promise you're making with your business.
Poignantly, Becker noted, "I understand venture capital is a game and we lost. Although I admit I thought it was more a game of chess and it's more a 'Game of Thrones.'"

While Becker's qualitative points should be heeded by founders, let's break down the technical aspects of the game and why he lost. One Twitter exchange in response to Lane's tweet above sheds some light.

What Lane is alluding to in the response above is liquidation preference overhang. While Lane calls it a "Game of Thrones" we likened this aspect of venture capital to a game of
 musical chairs, where the chairs are the money, and the VC always gets a chair. Let's unpack this some more.

Liquidation preference is a standard right for VCs which gives them a priority in being paid in the event of a liquidation (including a sale of the company). The market standard these days is a 1X preference, meaning the holder of that right gets paid back the principal of their investment before further distributions are made (for example to common stock holders, like founders and employees). The "overhang" term refers to a situation where the valuation of the company is less than the outside money that has been invested into the company. According to CrunchBase, Get Satisfaction has raised a total of about $21 million dollars. In order for Lane to have been "washed out" it's very likely that the company was sold for less than $21 million, which Lane confirms above.

To dive deeper into the liquidation preference overhang, check out our earlier post All That Glitters Is Not Gold: Startup Valuations and the Liquidation Preference Overhang.

Links to websites outside of our domain do not constitute an approval or endorsement of the content on those websites.